Has the Natural Gas Deal Well Run Dry?

Good times for financial sponsors backing the natural gas industry are in the rearview mirror.

Private equity firms, taking advantage of the sluggish financing market last year and in 2009, struck joint venture deals with domestic natural gas producers who suffered from limited access to capital in the recession’s wake, injecting billions into drilling companies to get backing behind new and controversial extraction processes.

This created a production boom in vast regions like the Marcellus Shale, a lucrative and increasingly accessible stretch of land across the Northeast only recently made ripe for harvesting. Soon after, clamoring strategics made PE firms’ newest energy assets substantially more valuable, seemingly overnight. In late 2010, both KKR and Avista Capital Partners exited natural gas exploration investments after abbreviated holds to strategic buyers Royal Dutch Shell and Reliance Industries, respectively, netting solid returns. Private equity firms continue to target the natural gas space in North America for investment, although they are appearing in deal headlines with less frequency lately.

But domestic natural gas reserves are approaching capacity and the price of natural gas as a commodity has remained depressed. Thanks to improved drilling capabilities, natural gas companies continue to extract more resources from deeper within the earth, guided by the belief that natural gas prices have hit, or are at, a bottom.

At least that’s what Grant Thornton believes. The advisory firm’s 2011 Survey of Upstream U.S. Energy Companies is bullish on natural gas prices even with reserves growing; it predicts that in 2013, its price will increase by more than 20 percent. Improved margins in the space will maintain financial sponsors interest and certainly, with oil prices skyrocketing as investors are made nervous of political instability in the Middle East, natural gas’ viability as an energy source appears only more attractive.

“I would expect to see several more joint ventures announced this year,” said Avista Capital Partner Robert Cabes. “These unconventional plays require significant capital to develop.”

While PE firms like Avista, KKR, TPG and Carlyle have each made numerous investments and across the natural gas space, more recently, foreign strategics have sought investments and acquisitions in North America. With some drilling companies eagerly embracing bigger strategics’ JV terms, as well as others taking advantage of much improved lending terms, these companies may increasingly become the dominant players in the joint venture pool once ruled by financial sponsors.

Reliance Industries, intent on developing U.S. natural gas plays as well as replicating extraction capabilities back with its lucrative Indian territories, has struck deals here (like its $1.3 JV with Pioneer Natural Resources last year through which it acquired gas properties in Texas) and at home (pairing off with BP to source, develop and market natural gas properties in India). PetroChina, Asia’s largest oil and gas producer, will also seek out North American resources assets, its chairman recently acknowledged, and CNOOC Ltd., China’s top offshore producer, already has, with its $1.1 billion stake purchase from Chesapeake Energy Corp.

The convergence of PE firms and strategic bidders on asset-rich properties has boosted deal premiums to levels unseen in recent years, according to Charles Dewhurst, international liaison partner with BDO in Houston. Cabes, whose Avista Capital continues to invest in the Marcellus and other gas producing regions, says he has noticed auctions become increasingly crowded, particularly with strategic bidders. If natural gas as a commodity is indeed bound for a rise, only limited opportunities in a frothy market remain for private equity sponsors.